A settlement bank is a bank that makes the final transfer of funds in a payment or card system, either for its own business or on behalf of other firms that do not settle with the system directly. Once a system has worked out who owes what, the settlement bank's account is debited or credited, usually in central bank money, and that entry is what turns a promise to pay into a completed payment.
The phrase is used in two related senses. In interbank systems such as CHAPS in the UK, a settlement bank is a direct participant that holds an account at the central bank. In card schemes, it is the bank an issuer or acquirer names to pay or receive its daily net position with the scheme. A settlement bank is not the same as a clearing bank, which exchanges and processes payment messages, although one institution often plays both roles.
Settlement banks in plain terms
Picture a group of friends who share restaurant bills for a month and keep a running tab. At the end of the month someone has to hand over real money. Rather than everyone paying everyone else, a few of the group who have bank accounts do the actual paying, and the rest square up with them privately. Those few are doing the job of settlement banks.
A payment system works the same way on a much bigger scale. Thousands of banks, payment firms and card issuers send money back and forth all day, but only some of them hold an account at the place where the final transfer happens. The others use one of those account holders as their agent. The agent pays and collects for them, then settles up with each client on its own books.
How a settlement bank works
Every payment system has a clearing stage, where instructions are checked and positions calculated, and a settlement stage, where money actually moves. In a real-time gross settlement system each payment settles one by one across the settlement banks' accounts. In a deferred net settlement system, payments are added up over a cycle and only the net amounts are settled, often several times a day.
Firms that do not settle directly, known as indirect participants, hold accounts with a settlement bank instead. When an indirect participant's customer sends a payment, the settlement bank pays it out from its own central bank settlement account and debits its client. This arrangement is called tiering. It saves smaller firms the cost of direct membership, but it means the settlement bank often lends to its clients during the day, a form of intraday credit, until their incoming funds arrive.
Settlement banks in interbank systems
In the UK, the term has long been used for the direct participants of CHAPS, which settle across accounts in the Bank of England's RTGS system. The same accounts also settle the net positions of retail schemes such as Faster Payments. Until 2017 only banks and building societies could hold them; in July 2017 the Bank of England opened settlement accounts to non-bank payment service providers, and TransferWise (now Wise) became the first to use one in April 2018.
In the United States, banks with a Federal Reserve master account settle directly through Fedwire, while many smaller institutions rely on a correspondent bank to act as their settlement agent. In foreign exchange, Continuous Linked Settlement (CLS) uses a similar structure: a limited group of settlement members deal with CLS Bank directly, and other banks and funds settle through them as third parties.
Settlement banks in card schemes
Card networks such as Visa and Mastercard do not move cardholders' money themselves. After each day's transactions are cleared, the scheme calculates a net amount for every issuer and acquirer, after interchange and scheme fees. Each member names a settlement bank, which pays the scheme if the member owes money or receives funds if it is owed. The acquirer then pays its merchants, and the card issuer collects from its cardholders under the card agreement.
For a fintech issuing cards through a partner, the settlement bank is often the same institution as its sponsor bank, which holds the scheme membership. Schemes may ask members to post collateral or keep reserves with the settlement bank so that a member's failure does not leave the rest of the network short.
Risks and safeguards
Settlement banks concentrate risk. If one fails partway through the day, its clients may not receive funds they were expecting, and the system may have to unwind or recalculate positions. That is the core of settlement risk, and it is why central banks prefer that major participants settle directly and why tiered arrangements are monitored by regulators.
Several safeguards limit the damage:
- Legal protection of finality. Laws such as the EU's Settlement Finality Directive make settled transfers irreversible even if a participant becomes insolvent, which supports payment finality.
- Collateral and limits. Central banks lend intraday only against collateral, and settlement banks set limits on how far their clients may overdraw.
- Prefunding. Some net settlement schemes require participants to hold enough at the central bank to cover their largest possible net debit position.
- Timetables. Payments must reach the system before its cut-off time, so that the settlement bank can manage its liquidity before close.